US Regulation of hedge funds—including digital asset funds—is conducted at two levels: (i) the issuer-level and (ii) the adviser-level. At the issuer level, the SEC and individual states regulate investment into the fund by US fund investors. At the adviser level, managers are regulated by either the SEC, CFTC, or neither based on whether the portfolio assets are classified as securities or commodities.
- Issuer-Level Regulation
The US Securities Act and corresponding state law govern all investments into the fund, based on the domicile of the individual investors; the fund’s intended portfolio asset classification, as well as the location and jurisdiction of the fund vehicle and/or fund managers, are irrelevant. These are considered private securities offerings under US law. Digital asset funds have few distinctions from similarly structured hedge funds at the issuer-level. Most of the registration exemption nuances affecting digital asset funds are based on adviser-level issues, where the classification of the portfolio investments is jurisdictionally determinative. However, disclosure issues are performed at the issuer-level and are addressed in the fund’s offering documents, as well as in statements made in the capital raising process.
- Exemption from Securities Act Registration
Section 4(a)(2) of the Securities Act exempts from registration transactions by an issuer that does not involve a public offering or distribution. Likewise, Regulation D provides safe harbor exemptions from Securities Act registration; if Regulation D’s requirements are met, Section 4(a)(2) exemption is satisfied. Hedge funds and other private funds usually rely on Rule 506 of Regulation D for exemption from public securities offering registration. Rule 506 of Regulation D allows issuers to raise an unlimited amount of capital from accredited investors without registration.
Registration exemption is accomplished at the federal level through limited notice filing obligations with the SEC, and at the state level through limited notice filing obligations with the respective states where the investors are domiciled. Registration exemption requirements are light, provided that investors meet the accreditation standard.
- Exemption from Investment Company Act Registration
The Company Act requires public registration of pooled investment vehicles and imposes substantial compliance burdens on public funds, including liquidity, diversification, and short trading limitations, as well as restrictions on transaction-based compensation, which are unsuitable for private fund managers.
Hedge funds and private equity fund managers typically satisfy the exemption requirements either under Section 3(c)(1) or 3(c)(7). Section 3(c)(1) is for small funds with less than 100 investors. Section 3(c)(7) is for funds with up to 2,000 investors and requires a higher investment standard for investors, known as the ”qualified purchaser” standard, than Section 3(c)(1). Both 3(c)(1) and 3(c)(7) are self-executing exemptions and require no overt filings for the exemptions to take effect, so long as the provisions are satisfied.
- Adviser-Level Regulation
US Regulation of private fund managers at the adviser-level is dependent on the classification of the portfolio assets as securities or commodities under the Investment Advisers Act (SEC) and the Commodities Exchange Act (CFTC).
- The Investment Advisers Act and the SEC
The Investment Advisers Act of 1940 governs advisers who provide advice on securities. As with issuer-level securities regulation under the Securities Act and Investment Company Act, investment adviser regulation under the Investment Advisers Act (and applicable state advisory laws) has both registration provisions—although certain fund managers may be exempt—and anti-fraud provisions, which apply to both registered and exempt managers.
For managers of pooled investment vehicles, the “advice” is provided to the fund, rather than to individual investors, as with non-fund advisers of separately managed accounts. Registration with the SEC would subject digital asset funds to adviser-level registration, reporting, recordkeeping, and SEC examination. More crucially, registration would trigger the full application of the Investment Advisers Act’s custody rule, which remains a key obstacle for compliance when trading liquid digital tokens.
Digital asset funds that trade even minimal levels of securities assets are subject to the investment adviser registration requirements. SEC advisory rules contain no de minimus exemption for the inclusion of insignificant levels of securities assets within the portfolio, as is the case under the CFTC registration and exemption framework.
- Available Exemptions
There are two key exemptions relied upon by most virtual asset fund managers: (i) the venture capital adviser exemption, available to managers of certain private equity and venture capital funds that invest in private companies; and (ii) the private fund adviser exemption, available to managers with less than $150 million in assets under management.
Beyond these two key exemptions, the SEC also offers a family office exemption available to advisers of funds comprising lineal descendant family investors from a shared ancestor. In addition, the SEC provides an exemption rarely relied upon by private fund managers for non-US advisers with less than $25 million in assets under management and fewer than 15 clients (or fund investors), known as the Foreign Private Adviser Exemption. The Foreign Private Adviser Exemption is principally used by advisers of separately managed accounts, as well as fund managers that also advise public funds or separately managed accounts in the United States.
Digital asset fund managers that satisfy the Venture Capital and Private Adviser Exemption are exempt from SEC adviser registration and—subject to limitation for advisers with a principal place of business in certain states—are not subject to direct application of the custody provisions of Rule 206(4)-2 of the Advisers Act. Exempt reporting Advisers are, however, subject to the reporting, record keeping, and SEC examination requirements, and are required to file as an exempt reporting adviser annually. The Foreign Private Adviser Exemption, by contrast, is not required to file an exempt report adviser filing and does not subject advisers to the reporting, record keeping, and SEC examination requirements.
Regardless of registration or exemption, all advisers that solicit or accept US investors, or have a place of business in the United States are subject to the anti-fraud provisions of the Investment Advisers Act, which have significant liability for statements made to investors or prospective investors. Rule 206(4) of the Advisers Act, applying only to pooled investment vehicles such as hedge funds and venture capital funds, imposes specific civil and criminal liability for false or misleading statements or material omissions made to investment fund investors. Notably, Rule 206(4) imposes liability on a fund manager even if the misleading statements or material omissions were not “willful,” but merely negligent.
- State Registration
US funds exempt from SEC registration under the Private Fund Advisers Exemption are regulated at the individual state level under the applicable state’s investment adviser regulation until the fund reaches the $150 million threshold. The principal place of business from which the fund provides most of its advisory services determines state jurisdiction.
Most US states provide for an exemption from state-level registration, with many requiring the filing of the SEC exempt reporting adviser filing, even below the $25 million threshold. Some states, such as Washington, Louisiana, and Utah require full investment adviser registration at the state level. State registration would trigger custody provisions similar to that of the SEC, such that funds with managers principally located in these states should avoid liquid digital asset strategies.
For an in-depth discussion on SEC and CFTC regulation of startup cryptocurrency hedge funds, please see our blog post here.